Retail real estate is a subsector of the commercial real estate industry. While the commercial sector comprises properties such as land and buildings, the retail property is more specialized. Commercial real estate comprises of shopping, entertainment, and dining establishments. Historically, these properties have been favored by investors because they offer higher chances for big profits than multifamily properties. A well-connected or inventive investor may be able to uncover hidden value in retail assets that others cannot, so presenting investors with the possibility of outsized returns.
Consider the Existing Commercial Rent Roll
When first considering the purchase of a retail property, an investor must assess the quality of the current tenants. Exist any quality tenants with an institutional-grade corporate guarantee on the lease, or is the property occupied with little "mom-and-pop" shops? A corporate tenant is always more valued since future income is assured if the corporation continues to operate. If the property does not have institutional- or corporate-grade tenants, it is the responsibility of the prospective purchaser to do additional due diligence on the current tenants.
Investors should consider the current financial health of the operating businesses, the future viability of the business, and their confidence in the business's owner/manager. If an investor purchases a property only to discover that their new tenants cannot pay their lease rents, the investor faces a major problem. A comprehensive analysis of the historical rental payments and the financials of the tenants is essential for ensuring the stability of the asset. In addition to forcing their tenants to sign a personal guarantee on the lease, commercial retail property owners can reduce their investment risk by requiring renters to sign a personal guarantee committing them to timely rent payments.
An investor must also consider the effect of an anchor tenant. An anchor tenant, also known as a prime tenant, a draw tenant, or a major tenant, is a prominent, well-known business that leases a significant amount of retail space in a specific retail complex. Anchor tenants are intended to attract customers to your retail space, hence increasing sales for your other tenants. Occasionally, the anchor tenant will receive a significantly reduced lease rent to increase the overall success of the retail mall. Properties with a high-attraction anchor tenant, such as a Whole Foods Supermarket or Apple Store, are typically more valuable since the anchor attracts tenants to the spaces surrounding it, hence raising the asset's total value.
Analyze the Retail Property's Future Potential
A retail property investor must evaluate the current in-place rent for all in-place leases, prospective lease escalations, CAM reimbursements, unoccupied space, current market rent, and market projections. Valuing the existing rent roll is crucial since it determines how much debt may be obtained against a property. Typically, while utilizing conventional finance, a lender will only lend based on the existing cash flow. Experts in real estate recommend that investors acquire properties with a Debt-Service Coverage Ratio (DSCR) of at least 1.2. If the business goal is to increase rents on existing tenants, lease unoccupied space, or construct new space, the investor should wait until this income is realized before obtaining more debt financing for the property.
When determining the projected return on a property, future lease increases must be accounted for. For instance, if a property's leases do not expand and remain steady, an investor could lose money as running expenses and property taxes rise over time. Therefore, the investor should pay a lower initial price for the property to compensate for the loss of future income.
Leasing unoccupied space is one of the primary ways to create significant profits on retail property. An investor must conduct market research and determine the market rent per square foot for their property based on comparable signed leases in surrounding buildings. The future development surrounding a retail area can also significantly boost the property's value, and timing might be crucial. If an investor learns that a highly desirable tenant is moving into a space adjacent to a property they own, it may be advantageous to delay leasing until the neighboring tenant is in place. As a new tenant often increases the desirability of an area, more retailers may be interested in your site.
Plan Appropriately for Future Leasing Expenses
Depending on the business strategy, some items, such as deferred maintenance, tenant improvement budgets, broker fees, free rent periods, and interest reserve, must be budgeted in advance for successful execution. Depending on the condition of the property, various transactions will have varying capital expenditure requirements. Some homes may require roof replacement, HVAC system improvements, elevator renovations, façade repairs, etc. This is work that must be performed regardless of the building's occupancy status and is designated as an immediate requirement.
Costs associated with tenant leasing will vary from market to market and depend on whether the market favors landlords or tenants. If a new buyer is funding a transaction that entails leasing unoccupied retail property to a new tenant, they will negotiate the appropriate scope of work for the new tenant. This may consist of as little as a "white box," which is simply a blank canvas for the tenant's own improvements. Tenant enhancement funds can also be negotiated such that the landlord pays for any new construction for the use of the future tenant.
Additionally, the new tenant may negotiate an initial rent-free period to help them get their firm off the ground. The landlord must account for the downtime and have sufficient funds budgeted to cover the tenant's new expenses and debt payment obligations. In addition to these costs, landlords typically employ a leasing agent to find a tenant. Leasing costs range from 2% to 5% of the entire lease value and are negotiated prior to the broker commencing work. Before purchasing the property, the astute investor will know just how much each of these items will cost in order to collect sufficient funds to cover the Capex, operational expenditures, and debt payment.
Optimize Profits with the Best Lease Option
As an investor signs new leases with new tenants, he or she must critically consider how the terms will be written. The lease arrangement can be significant in deciding the viability of an investment. There are numerous methods for preparing an egg, and establishing a retail lease is no different. There are three primary types of retail leases, including gross, net, and modified gross leases.
In a gross lease, all property operating expenditures are covered by the tenant's rent. These costs may include property taxes, electricity, upkeep, etc. These expenditures are covered by the tenant's rent, which is paid by the landlord. As a result, the tenant's only outlay is typically the high base rent. Tenants tend to favor this sort of lease because they are not required to participate in the day-to-day operations of the building and the rent is fixed even if expenses fluctuate. For instance, throughout the summer, rent will remain unchanged despite the increased energy expenditures associated with air conditioner use.
The net lease is a commercial real estate lease that is extremely adjustable. A net lease has a lower base rent than a gross lease, but the tenant is responsible for fixed operating expenses such as property taxes, insurance, and common area maintenance. In a single net lease, tenants pay a fixed rent in addition to a portion of the property tax that would normally be negotiated with the landlord. The landlord pays for construction expenses, but the renter pays directly for utilities and other services. A double net lease is similar to a single net lease, except that the tenant also pays a portion of the property tax and property insurance. The landlord is responsible for maintaining the common areas, but tenants are responsible for their own utilities and trash removal. The renter pays for some or all of the costs of property taxes, insurance, and common area maintenance in addition to their base rent under a triple net lease. It is one of the most prevalent types of leases.
The modified gross lease (or modified net lease) is the third major type of commercial real estate lease and provides a fantastic compromise for both renters and landlords. The modified gross allows for greater flexibility in operating expenditure discussions. As with the gross lease, the base rent will be subject to the terms agreed upon by both parties. The distinctive characteristic is that the lease payment is fixed, regardless of whether expenses rise or reduce.
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1031 Risk Disclosure:
- * There is no guarantee that any strategy will be successful or achieve investment objectives;
- * Potential for property value loss - All real estate investments have the potential to lose value during the life of the investments;
- * Change of tax status - The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities;
- * Potential for foreclosure - All financed real estate investments have potential for foreclosure;
- * Illiquidity - Because 1031 exchanges are commonly offered through private placement offerings and are illiquid securities. There is no secondary market for these investments.
- * Reduction or Elimination of Monthly Cash Flow Distributions - Like any investment in real estate, if a property unexpectedly loses tenants or sustains substantial damage, there is potential for suspension of cash flow distributions;
- * Impact of fees/expenses - Costs associated with the transaction may impact investors' returns and may outweigh the tax benefits